Экономическое обозрение Национального Банка Республики Казахстан №2, 2018 (стр. 9 )

Central banks conduct monetary policy under some sort of monetary policy regime which provides a framework for monetary policy ch a framework facilitates decision-making process and enables the decisions to be communicated more easily to the public. The primary objective of the overwhelming majority of central banks while maintaining price stability is the correspondent aim of controlling inflation, which is also one of the goals of macroeconomic policy because unanticipated or extreme cases of inflation may affect employment, investment and returns.

Potential implications of unexpected inflation may be adverse bringing about a destabilizing impact to the economy and economic agents such as the reduction in the information content of market prices, arbitrary transfer of wealth between borrowers and lenders, higher risk premium in borrowing rates and the prices of other assets. Overall, unanticipated dynamics in the market price level may aggravate economic expansion or result in deeper contraction or trough.

Thus, central banks work to achieve monetary policy objectives through open market operations, the refinancing rate, and reserve requirements. One of the most direct ways for a central bank to increase or reduce the amount of money in circulation is via open market operations, involving the purchase and sale of government bonds from and to commercial banks and market makers. Another tool is the benchmark official policy rate, which affects the whole economic process through short - and long-term interest rates and ultimately real economic activity as this rate reflect the collateralized lending rates to the commercial banks.

Central banks may adjust liquidity conditions through setting the benchmark official policy rate. If economic activity is likely to lead to an increase in inflation, central banks take contractionary measures through the reduction of liquidity by increasing interest rates. In the event the economy is slowing and inflation and monetary trends are weakening, central banks conduct expansionary policy by increasing liquidity and reducing the target rate.

Another primary tool to limit or increase the supply of money is via reserve requirements. A central bank restricts money creation by raising the reserve requirements of banks. However, some central banks, for instance, the Bank of England do not set minimum reserve requirements for the banks under their jurisdiction anymore as frequent changes of reserve requirements may cause disruptions. On the other hand, reserve requirements may still be used in many countries to control lending, for instance in China and in India [31].

Monetary policy regimes

Inflation Targeting

Aforementioned tools are used in the framework of conducting specific monetary policy regime. Over the 1990s, a consensus began to build among both central bankers and politicians that the best way to curb the inflation and thereby maintain price stability was to target a certain level of inflation.

Under the inflation targeting, the central bank publicly pre-announces an inflation target (or a succession of targets) that it is determined to achieve. This involves active and direct shaping of inflation expectations. This regime's decision-making scheme involves the use of much more information than merely the exchange rate or monetary aggregates, covering the labor market, import prices, producer prices, the output gap, nominal and real interest rates, the nominal and real exchange rate, public budgets, etc. An inflation-targeting framework normally has the following set of features: an independent and credible central bank, a commitment to transparency, a decision-making framework that considers a wide range of economic and financial market indicators, a clear, symmetric and forward-looking medium-term inflation target.

Exchange Rate Targeting

Many developing economies select their currency’s exchange rate targeting as a monetary policy response. The central bank tries to ensure nominal exchange rate stability in relation to the currency of a so-called anchor country via interest rate changes and direct foreign exchange interventions, thereby "importing" price stability from the country. Maintaining the exchange rate requires an appropriate economic policy mix ensuring a low inflation differential vis-а-vis the anchor country, a sufficient level of international reserves, and maintaining of the country's competitiveness and overall credibility, including its institutional and legislative framework and political stability. One of the major disadvantages of the regime is the loss of monetary policy autonomy.

In response to the central bank measures to target an exchange rate, interest rates and conditions in the domestic economy must adjust to reach this target, leading to domestic interest rates and money supply gaining more volatility. Despite these risks, many economies peg domestic currency exchange rates to other currencies, most often the US dollar. Sample countries - the Netherlands Antilles and Qatar practice a fixed exchange rate.

Monetary targeting

This regime focuses on the growth rate of a chosen monetary aggregate, based on the finding that in the long term, price growth is affected by money supply growth. A problem, however, lies in the choice of an appropriate monetary aggregate to target. In an environment of financial innovation, market computerization and globalization, the relationship between monetary aggregates and the price level is becoming ever weaker. The central bank may also fail to manage the selected monetary aggregate with sufficient precision.

The ultimate goal of this policy is the price stability, balanced economic growth and the operational goal is the monetary base/balance components of the central bank.

Regime with an implicit nominal anchor

A regime with an implicit nominal anchor involves targeting a particular nominal variable adopted only internally within the central bank without it being announced explicitly. A prerequisite for successful functioning of this regime is high credibility of the central bank, which enables the desired changes in inflation or inflation expectations to be achieved without explicit targets.

It should be noted that the implementation of the monetary policy may begin to work through the economy via four interrelated channels. Those channels include bank lending rates, asset prices, agents’ expectations, and exchange rates. First, the base rates of commercial banks and interbank rates may rise in response to the increase in the official policy rate. Banks would, in turn, increase the cost of borrowing for individuals and companies over both short - and long-term horizons. Businesses and consumers would then tend to borrow less as interest rates rise. An increase in short-term interest rates could also cause the price of such assets as bonds or the value of capital projects to fall as the discount rate for future cash flows rises [31].

Developing economies often face significant impediments to the successful operation of any monetary policy—that is, the achievement of price stability. These include: the absence of a sufficiently liquid government bond market and developed interbank market through which monetary policy can be conducted, a rapidly changing economy, making it difficult to understand what the neutral rate might be and what the equilibrium relationship between monetary aggregates and the real economy might be, rapid financial innovation that frequently changes the definition of the money supply; a poor track record in controlling inflation in the past, making monetary policy intentions less credible, and an unwillingness of governments to grant genuine independence to the central bank [32].

Market participants would then come to the view that higher interest rates will lead to slower economic growth, reduced profits, and reduced borrowing to finance asset purchases. Exporters’ profits might decline if the rise in interest rates causes the country’s exchange rate to appreciate. The fall in asset prices as well as an increase in prices would reduce household financial wealth and therefore lead to a reduction in consumption growth. Expectations regarding interest rates can play a significant role in the economy. Often companies and individuals will make investment and purchasing decisions based on their interest rate expectations, extrapolated from recent events. If the central bank’s interest rate move is widely expected to be followed by other interest rate increases, investors and companies will act accordingly. Consumption, borrowing, and asset prices may all decline as a result of the revision in expectations.

If inflation expectations rise perhaps following a rapid increase in oil prices expectations could get embedded into wage claims and eventually cause inflation to rise. There is a whole range of interconnected ways in which a rise in the central bank’s policy rate can reduce real domestic demand and net external demand (the difference between export and import consumption). Weaker total demand would tend to put downward pressure on the rate of domestic inflation—as would a stronger currency, which would reduce the prices of imports. Taken together, these might begin to put downward pressure on the overall measure of inflation.

In the course of implementation of the monetary policy it is crucial, therefore, to identify the sources of potential shocks to the inflation rate. For instance, if inflation is rising in a way that threatens price stability central banks or other monetary authorities should determine whether this deviation was caused by greater consumer or business confidence, which resulted in higher consumption and investment growth rates, then it could be classified as a demand shock and it might be prudent to undertake contractionary monetary policy to bring the inflationary pressures under control. On the other hand, if instead rising inflation was caused by greater oil price, the country is experiencing a supply shock, and raising interest rates or contractionary policy might aggravate the situation as higher interest rates may exacerbate the oil price-induced downturn [31, 33].